Contract Costing

For a layman Contract means “Agreement between two persons in relation to something specific” E.g. employment, lease, insurance, purchase & sale of product or service etc. Actual dictionary meaning is – “A written legal agreement” or “to make something smaller or shorter”. For our study purpose, contract would mean a written legal agreement in respect for construction of roads, dams, bridges, highways, buildings, etc. The calculation of cost and profits in respect of these contracts is the entire objective of Contract Costing.

Contract costing is a form of
1. Specific order costing
2. Where job undertaken is relatively large and
3. Normally takes period longer than a year to complete.
This method of costing basically deals with companies which are engaged in construction of roads, dams, bridges, highways, buildings, setting up of plant, malls, townships, engineering projects, etc. The two parties of the contract are contractor and contractee. Contractor is a person / entity who constructs the said asset i.e. undertakes construction. Contractee is the person / entity who has given the construction work. Burj Khalifa was made by Samsung C&T (contractor) and the owner being Emaar Properties (contractee). The price at which the construction takes place is called as Contract Price. It is stated on the first day while entering into contract which is arrived on the basis of estimated cost and profits to be earned. All the terms and conditions in respect of the contract once agreed are made contractual through contract deed.

1. The major part of the work in connection with each contract is ordinarily carried out at the site of the contract.
2. The bulk of the expenses incurred by the contractor are considered as direct.
3. The indirect expenses mostly consist of office expenses, stores and works.
4. All costs are usually accumulated and ascertained for each contract and a separate account is maintained for it.
5. The number of contracts undertaken by a contractor at a time is not usually large.
6. Each contract is treated as a cost unit.
7. Here we majorly interested in preparing books of contractor. This is where learning applies because in this chapter we have two entries in respect of contractee. First on receiving cash from contractee i.e. Cash / Bank A/c Dr. To Contractee & second on transfer of contract on completion i.e. Contractee A/c Dr. To Contract A/c

A contract takes longer period to complete and the result of the contract can be known only after the completion of the contract. To have a better control over the contract and cost, it is necessary to have an idea of profitability of contracts at regular intervals or at least once in a year. For this purpose, a contractor needs to calculate expected profit or notional profit for a contract. It also helps in profit comparison for a period and provides a good basis for performance measurement and evaluation of those who are engaged in the contract. The expected or notional profit in respect of each contract in progress (i.e. incomplete contracts) is transferred to the costing profit and loss account (consolidated) for the year to determine overall profitability of the contractor.

RECORDING OF CONTRACT COSTS ON CONTRACT BY CONTRACTOR [TO GET CORRECT ENTERIES THINK AS IF “U” R D ACCOUNTANT OF CONTRACT] {DON’T JUST READ – THINK*}

(a) Materials may be purchased in bulk by the company and kept in stores. The same materials is then supplied to the contract on demand; journal entry for which is as follows

Contract A/c…………………………..Dr.
To Stores Ledger Control (SLC) A/c.

(b) Materials may be purchased and directly supplied to the contract;
Contract A/c…………………………Dr.

To Store supplier’s A/c / Cash/Bank A/c.
(c) Materials returned to stores;
SLC A/c…………………………………Dr.
To Contract A/c.
(d) In the case of transfer of excess material from one contract to another, cost of these excess materials are adjusted on the basis of Material Transfer Note;
Contract Account (Contract No. XYZ) ……………. Dr.
To Contract Account (Contract No. ABC).
(e) In case of materials sold either at profit or loss;
Cash/Bank A/c…………………………………….Dr.
Costing Profit & Loss A/c……………………..Dr (If loss)
To Contract A/c.
To Costing Profit & Loss A/c (If gain).
(f) In case of abnormal loss of materials either due to theft or destruction etc. the same is transferred to Costing Profit & Loss A/c;
Costing Profit & Loss A/c………………………Dr
To Contract A/c.
(g) If the contractee has supplied some materials without affecting the contract price, no accounting entries will be made in the contract account, only a note may be given about it.

(a) Workers employed on the contract site are regarded as direct employees (irrespective of the nature of the task performed) and the wages paid to them are charged to the concerned contract directly.
Contract A/c………………………………….Dr.
To Labour A/c.
(b) If an employee is engaged concurrently in other contract also then the total wages paid is apportioned to the contacts on some reasonable basis, usually on time basis.

The expenses which can be directly charged to different contracts will be posted directly to the respective contracts. These include cost of special tools, cost of design, electric charge, insurance etc.
Contract A/c………………………Dr.
To Direct Expenses A/c

Indirect expenses (such as expenses of engineers, surveyors, supervisors, corporate office etc.) may be distributed over several contracts on certain reasonable basis as overheads.
Contract A/c………………………………. Dr.
To Overheads A/c

The value of the plant in a contract may be either debited to contract account and the written down value thereof at the end of the year entered on the credit side for closing the contract account, or only a charge (depreciation) for use of the plant may be debited to the contract account.
Contract A/c………………………………. Dr.
To Plant and Machinery A/c (with cost)
&
Plant and Machinery A/c (with WDV) ……………. Dr.
To Contract A/c

Or
Contract A/c………………………………. Dr.
To Depreciation on Plant and Machinery A/c

Sub-contract costs are also debited to the Contract Account.
Contract A/c………………………………. Dr.
To Cost of Sub-Contract A/c

The extra work amount payable by the contractee should be added to the contract price. If extra work is substantial, it is better to treat it as a separate contract. If it is not substantial, expenses incurred should be debited to the contract account as “Cost of Extra work”.
Contract A/c…………………………… Dr
To Cost of Extra Work A/c
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TWork certified is that portion of the work completed which has been certified or approved by the contractee’s architect / valuer / surveyor. It is always valued as some % of contract price and hence includes profit.
The value of work certified is debited to the Work in progress A/c and credited to the contract A/c. The calculation of Work certified is as under:

Value of Work Certified
= Contract Price x Work Certified as % of Contract Price.
OR
= Cash received / Cash received as % of Work Certified.

Work uncertified is that portion of work completed which has not been certified / approved by the contractee’s architect / valuer / surveyor. It is always valued at cost price. The cost of work uncertified is debited to the Work in progress A/c and credited to the contract A/c. The calculation of Work uncertified is as under:
Cost of Work Uncertified
= Total cost incurred till date – Cost of Work certified.
OR
= Total cost incurred till date x (% of Work Uncertified / % of Total work done till date)

When a contractor is engaged on a contract for several years, he cannot afford to block a large amount of funds until the completion of the contract. Therefore, in case of large contracts the system of progress payment is adopted. The contractee agrees to pay a part of the contract price from time to time depending upon satisfactory progress of the work. The progress will be judged by the contractee’s architect, surveyor or engineer who will issue a certificate stating the value of work so far done and approved by him.
Practical Scenario: Whenever an asset(generally house) is bought in an under construction project, the builder charges the clients on slab basis i.e. on completion of 1st
Slab pay 10 %, 2nd slab next 10% as so on till completion. This payment system is nothing but progress payment.
Progress Payments
= Value of Work Certified – Retention Money – Payments to date.

The terms of the contract provide that whole of the amount shown by the certificate (work certified) shall not be paid immediately but a percentage thereof shall be retained by the contractee until sometime after the contract is completed. The sum retained is called retention money. Usually the contractor may be paid 75% or 80% of the work certified depending upon the terms of the contract. The objective of this retention is to place the contractee in a favourable position in case the contractor does not fulfill some of the conditions laid down by the contract or in case of faulty work.
Retention Money
= Value of Work Certified – Payments actually made.

It is ascertained by deducting the retention money from the value of work certified i.e.
Cash Received = Value of Work Certified – Retention money

It represents the difference between the value of work certified and cost of work certified. It is always calculated for each and every year of the contract and the amount of profit or loss of every contract is transferred to the company’s Costing Profit & Loss A/c. It is determined as follows.
Notional Profit
= Value of work certified – Cost of work certified
OR
= All credit values – all debit values
OR
= Value of Work certified – (Total Cost incurred till date – Cost of work uncertified)

It is the excess of the contract price over the estimated total cost of the contract. It is always calculated for the entire contract. One can calculate estimated profit only when the cost to be incurred in near future can be estimated on some rational basis.
Estimated Profit
= Contract Price – Total estimated cost of contract (cost incurred till date + estimated cost of completion)

a. Contract whose value of the contract is ascertained by adding a certain percentage of profit over the total cost of the work.
b. This is used in case of those contracts whose exact cost cannot be correctly estimated at the time of undertaking a work.
c. The profit to be paid to the contractor may be a fixed amount or it may be a particular percentage of cost or capital employed.
d. These types of contracts are undertaken for production of special articles not usually manufactured and is generally employed, when Government happens to be a contractee. Generally, in such contract, contractor and contractee have clear agreement about the items of cost to be included, type of material to be used, labour rates for different grades, normal wastages to be permitted and the rate or amount of profit.

a. Cost plus contract ensures that a reasonable profit accrues to the contractor even in risky projects.
b. It simplifies the work offering tenders and quotations.
c. It provides escalation clauses and thus covers the contractor from fluctuations in price and utilisation of elements of production.
d. The customer is assured of paying only reasonable amount of profit.
e. The customer has the right to conduct cost audit so that he can ensure that he is not being cheated by the contractor.

Inspite of the advantages mentioned above cost plus contract system has the following disadvantages:
a. Since the contractor is assured of profit margin, he may not take initiative for cost reduction by affecting economies of production and reducing wastages.
b. The ultimate price to be paid by the customer cannot be exactly ascertained until the work is completed and this creates delay in preparing purchase budget by the customer.
c. The customer has to pay not only the resultant high cost but also the resultant high profit. Thus, customer has to pay substantially for lack of proper attitude (towards cost and efficiency) on the part of contractor.

Escalation clause is usually provided in the contract as a safeguard against any likely changes in the price or utilisation of material & labour beyond the control of contractor. This clause provides that in case prices of items of raw materials, labour etc. specified in the contract change during the execution of the contract, beyond a specified limit over the prices prevailing at the time of signing the agreement, the contract price will be suitably adjusted. The terms of the contract specify the procedure for such adjustment in order to avoid all future disputes. Thus this clause safeguards the interest of both the contractor and the contractee in case of fluctuations in the prices of material, labour etc. Do remember this clause will not compensate for inefficiency or wrong estimation on the part of contractor and we always pay the contractor for net increase.

Only two items are carried from the current year to the next year. 1st Closing WIP becomes Opening WIP in the next year & 2nd Closing material becomes Opening materials in the next year.

The profit arrived is called as actual profit and on the credit side instead of WIP we write Contractee’s A/c as in the last year the contract gets transferred to contractee and any materials left are either returned or sold as the case may be.

If one can foresee any loss in respect of a particular contract that will happen in the coming years than we should create provision in respect of such losses in the current year itself based on the principle of consistency.

Work-in-progress in contract costing refers to the contract which is not complete at the reporting date. In Contract Accounts, the value of the work-in-progress consists of :
(i) The cost of work completed, both certified and uncertified;
(ii) The cost of work not yet completed; and
(iii) The amount of estimated/ notional profit.
In the Balance Sheet (prepared for management), the work-in-progress is usually shown under two heads, viz., certified and uncertified. The cost of work completed and certified and the profit credited will appear under the head ‘certified’ work-in- progress, while the completed work not yet certified, cost of material, employee and other expenses which has not yet reached the stage of completion are shown under the head “uncertified” work-in-progress.

Cost of word done / completed
= All expenses on debit side – Everything on credit side except work certified and work uncertified
Cost of Work Certified
= All expenses on debit side – everything on credit side except work certified
OR
= Cost of work completed – Work Uncertified.